Ep 58: What is Stock Lending?

Today, we are answering a question that one of our listeners submitted via email, which by the way is jessica@marketmakeherpodcast.com. Love that we have the same name and can do that, I do too. You never know which one you're going to get. That's right. I don't know if we can tell you though. OK. So James S. wrote in and asked this purely academic question. Should the retail investor participate in stock lending? And this is a great question because I'm pretty sure RobinHood asked me if I wanted to lend my stocks at some point like

I think before even this podcast and I called you up, Jess, and was like, hey, what is this? Should I do it? And you were like, yeah, go for it. But I didn't actually completely dive into that one. And I think it's time that we do it now. Yeah. I actually made a TikTok on that and it's still trending to this day. yeah. Yep. That's right. With the screenshot of your email. said, did you receive this email?

And also with my new job, I've had to open 19 brokerage accounts now at every single brokerage firm. And I noticed at every single brokerage firm and asked me if I wanted to participate in stock lending, which is very interesting. But I used to help people with this when I worked at Fidelity. So let's talk about what it is. Let's go. You're the right person to ask. Yay.

You're listening to Market MakeHer podcast, the self-directed investing education podcast that demystifies the world of investing so that we can all learn how to do it ourselves, but in a more relatable way from her perspective. We talk about current events like what the Fed is doing, educate and explain like what PCE is and why it matters. The Fed's preferred gauge of inflation and tell you actions you could consider at your brokerage firm. And for the record, this is not financial advice. It is definitely educational and for informational purposes only.

Disclosure, disclosure, disclosure. That's correct. And we do it teacher learner style. So I'm Jessie DeNuit. I'm here to learn how to invest with you as I'm on a mission to learn how this esoteric world of investing works so that we can all figure out how to make our money make money and not have to work toward ID. And I'm Jessica Inskip, what we call the resident financial expert. I've worked in the self-directed space for 15 years now. I was licensed for 10 of those years and I gave up my licenses to be able to share all of my knowledge with you.

And Jessie. And Jessie convinced me to start this podcast with her to make investing make sense. That's basically our phone calls, but publicly. And here we are, 58 episodes later. I can't believe that. I know. We're doing it. So let's get into the answer to the question our lovely listener submitted. I'm going to read it one more time in full. So James S. an email saying, should the retail investor participate in stock lending?

My cursory research makes me feel it is safer than selling covered calls and the 105 % surety offered by the brokerage houses decreases the risk. However, I do believe that brokerage houses take too large a percentage of the profit. I would love to hear your thoughts and comments. So maybe we should start with what exactly is stock lending? really want to comment on the options trading piece. So if anybody wants to talk about that, let us know in the comments. Yes, Jess is a

A mastermind at options. my specialty, but it's advanced. So we'll get there. I don't even, but I'm ready. So let's get into it. Let's figure it out. Let's learn together. Stock lending has to do with short selling. I think we talked about short selling for two minutes one time. I probably should explain that first. When you buy a stock, you buy the stock with the intent of it to go up in value. When you short a stock,

You sell the stock first, you sell a stock you do not own with the intent of it to go down in value. That's how you make money. That has to be crystal clear. so you're you're borrowing that stock from someone else when you do that? You have to. Yes, that's where stock lending comes into play. So you can understand the benefits of this and what the downside is. It's a lot. get a lot of questions on what is the downside of stock lending. It seems so too good to be true. Well, there is some downside. So we should definitely definitely talk about it.

So there is a regulation called regulation show, because you know the financial industry is super, super regulated. And what that means is you have to have a locate or a tag on every single security that is shorted, meaning you can't short naked, which it's in the name, it means it's not covered. you can't short securities that don't exist. Aw, naked, got it. Yeah, yeah. No one's creative. Yeah, everything is literally the name. It really is so literal. It really is.

when you are selling short a stock. So if I want to sell short SPY, example, SPY, the ETF that tracks the S&P 500, which would not be a good idea right now. But if you did, you can't just short it unless it's available to short. And there are a couple of ways that it is available to you as a self-directed investor, because self-directed investors can short as well as the institutional and everybody. Makes sense so far? Mm-hmm. So that's short selling. Right. You said everyone can do it, not just like hedge fund. Yeah, anyone can, but it requires a margin account.

If you wish to sell. So if participating in stock lending does not mean you have a margin account, margin just means you're borrowing and you have margin requirements. It's basically like a key lock on your account, the home equity line of credit. It's an equity line of credit, like literally on your equities, your stock positions. okay. That's what margin is. So there are requirements for margin, as in you have to own a percentage of it. And that changes

It could change intraday. It can change every single day. That's why margin can be risky because you could be required to meet that loan at any time. This episode is not about margin, but you need to know that to understand stock lending and what you're signing up for. So these are the people who leverage their account and you could do that as an individual investor. There's risk that's associated with it. A lot of risks. Your stock could be sold at any time because your account could go negative and the firm's always trying to protect you because they have a few to share your responsibility. So

things can happen very quickly because the market can move really quickly. Right. So when you sign up for a margin account, your stocks are immediately moved into margin type. I always describe this when I worked at the active trading desk as you think of your, actually as a house, you think of your brokerage account as a house. are rooms in your house. There is a margin room, which is where margin stocks are held.

There is a cash room, which is where cash stocks are held. And then there could even be a stock lending room. There are different rules in each of those rooms. OK. So when you hold something in margin and you put it in the margin room, your brokerage firm can take anything from that margin room and lend it out. You agree to that when you sign up for margin. wait. But stock lending and margin are different? They are related, but they are different. But if I sign up for stock lending or opt into stock lending,

Is it still happening in that margin room? It's happening in that margin room, but it's not originating from that margin room. OK. If that makes sense. OK. Well, in a way. So you, if you sign up for stock lending, you probably have a cash account. And because you have a cash account, the brokerage firm can't just take your shares of SPY that I want to short and give it to this other person to short. They have to ask your permission. When you say cash account, does that mean like you have a money market with your holdings in it or something? That means you don't have a margin account.

Okay, so a cash account is a regular account. Regular account. Okay. That's right. That's it. That's the difference. That might be the brokerage term speak right there. could say cash account, margin account. Okay. Type two, type one, they have numbers. which one's which? Type two is margin, type one is cash. That's what figured. Okay. Yeah. Anyways, that's very firm specific.

Those who work at the Green Frog know what I'm talking about. I'll just leave it there. Nonetheless, so when you have a cash account, you have to sign up for stock lending. So you can do that at Robinhood. can do it. it at all these brokerage firms offer it. saw it when I signed up for these accounts and you say, Hey, I'm willing to let you take my stock that I have and give it to a short seller to short because you are governed by regulation.

that says you have to show that you have those shares available. There is a locate for you. So it's normally within that brokerage firm. So if you want to offer short selling, you want to make sure you have the shares available to short, I'm going to give you my shares. That's what stock lending is. You're literally lending your shares to the brokerage firm to allow someone else to put in the margin room to short. OK. And when you're in the margin room, there is a margin requirement to short. But let me stop there. Does that make sense so far?

Yeah, so you opt into the stock lending program because you have a bunch of stocks. Is it just stocks or is it ETFs too? It can be ETFs too. Okay. So you have stocks and ETFs in your brokerage account and you get asked, hey, do you want to participate in the stock lending program? guess. And you say yes. And then the ones that you, I guess, does the firm decide which of your stocks, like they kind of look at your portfolio, like, hey, we want to take these specific stocks and put them.

in the stock lending room. Yeah, they do. So they have to be eligible securities. And then there is actually a lot that happens once you agree to it, because you could buy something and then add it to that lending. And even back when I worked on the active trader desk, we would call people before it was available to sign up for online and say, hey, we've got this program. Do you want to sign up for it? You can get 9 % of interest for this specific security, which back then when interest rates were zero is huge. And that's because

It goes by supply and demand. So each stock to short has a margin requirement, which just means the collateral you have to keep, which changes the percentage of the stock. And it changes because the stock price changes, but it's determined daily. There's also something called a hard to borrow rate. And that's where you're getting this interest. And it's charged daily. So if you hold it overnight, that's when it kicks in. And I've seen that as high as 80%. wow.

Yeah, it's huge. Well, because if everybody wants to short a specific security, like GameStop, I bet you that was on the hard to borrow list. Yeah. And it would have been very expensive to hold overnight because it's in excess demand. So there is a premium attached to holding it overnight. So people who are day traders who short the stock intraday, so throughout the trading day, they are not charged that hard to borrow rate. But if they hold it overnight, they are. That's the way it works.

What benefits you, if you participate in that and you have those hard to borrow securities, that interest rate is not set. So you do get a portion of it. Absolutely the brokerage firm is going to take a bigger portion. They do. Yes. Why? That's what they do. Yeah, exactly. have to make their money somehow. It's a business, and that's absolutely fine. But you tend to get an interest rate that's much higher than the target rate.

a lot higher, but it changes based on the security and supply and demand. A lot of people want to short it. If you own a stock that a lot of people want to short, then you're going to get a higher interest rate. It's really that simple. then maybe I'm getting ahead here, the people that are shorting the stock and borrowing it from you, like if they're borrowing my stock, but then they're trying to sell it to someone else, how does that work? Is that what they're doing? They're selling your stock to someone else and then what, buying it back and giving it back to you?

I guess where I'm confused is like, okay, I have this stock. It's in the stock lending room. And then from there, does it go into the margin room when it's like eligible for shorting? Yeah, it goes into their account. there is a, I think we called it type nine. I don't know why I remember this. this is very one brokerage firm specific. It's not type nine everywhere. This is one firm and somebody, I know people who work at this one firm are like, I know where she works.

I'm not going to say that. I use it as an example. Yeah, but it goes into that different type. So that different room. So it's you'll even see it as a separate line item on your your positions page when you logged in. You could clearly tell because what you're doing is you are giving up ownership now. You don't have voting rights on your stock because you lent it out. OK, the person who shorted the stock owes you dividends, but you don't give it in the form of dividend. You get cash in lieu.

So you still get your dividends. In order to qualify for the dividend, you have to own the stock the day before the X date, so the day to qualify for the dividend. So that's it. And then once the pay date comes, we'll have a negative cash taken from their account because they borrowed stock from you. They owe you a dividend because they borrowed that stock to sell it. And then someone else owns it, who knows where. That could go on forever. If you think about it, it's an infinite loop.

That's my brain going crazy. Then how does it get back to you though? So you can call it back at any time because you lent it out. You could say, you know what, I want my stock back. I want to sell it. But going back to that dividend and what you're giving up, you're giving up voting rights. You don't own the stock anymore. You by all means have the value of the stock. You're going to get the dividends, but it's not going to be classified as a dividend, which means it's going to be taxed differently. Yeah. I was going to ask that next.

But usually the company, so that 105 % guarantee that James is referencing, is part of also the cash and lieu dividend payments, meaning they're going to make sure that you get that. And there's regulations where they have to have collateral set aside, the firm does, to make sure that it can fully meet everything because they're lending out your securities. So meaning the risk is so taken off the table of you doing that because it's collaterally by the brokerage firm.

Okay. And that is very regulated. You are lending your stock. You don't get voting rights anymore. They then somebody is selling it, short selling it. That's right. Like ahead of ahead of owning it. So they're short selling it to someone else. And then how do you get that stock back? You just call your brokerage firm and say, Hey, I want to sell this. So if you want to sell it, you're going to have to, they'll have to cover their security or get another locate added to their account.

Okay. But you're, you're in charge here. You're the one who said, they've sold it to somebody. They have. Now they have to buy that same stock that I lent them back at whatever price it is now and give it back to me. Yeah, they may have to because that that's, that's really, really important point. That's why I started with regulation show there has to be shares available for you to short and I'll use SPY. Cause it's the most commonly traded security is SPY. Say you want that out. It was hard to borrow. And the person who wanted to short that stock.

They may have to physically call and say, Hey, the way I would do it at the brokerage firm I worked for, somebody would say, I want to short a thousand shares of this. Say, okay, let me find you a locate. I would call the back office, get a location, you get a tag and I would add it to their account. They had a thousand shares for that day that they could short sell. I would tell them the hard to borrow rate because if they called in, it was probably hard to borrow. So, Hey, FYI, Mr. Client, if you hold this overnight.

there is a 20 % hard to borrow fee associated with that. Say we got that locate from your account because you're in the stock lending program. It's hard to borrow. There is a fee that's associated with it. He shorts it. He holds it overnight. You're collecting a premium. And you're like, look at this cash coming in. The brokerage firm is getting a portion of that. You are entitled to the dividends, but it's not going to come in as dividends. And you're not entitled to voting rights. Now let's say you say,

I want to sell SPY now. I don't want this anymore. There's no more shares available. So that locate that was attached, the firm would be out of regulation if they can't match something together. Because you don't want to short shares more than what actually exists. That's bad. So he would get a force to buy to cover. You get your shares back, you're in charge. Buy to cover means you sold short. That's your first transaction. You buy to cover the short.

That's all that means. OK. He would have to do that unless there were other shares available. But that shouldn't affect you. That's just the other person. Yeah. And you don't know about the other person. OK. So being a stock lender, is it no risk or is there risk? Like, is there still a risk that you might not get your stock back or something or they have to no matter what? Yeah, they have to. You are not covered by SIPC at that point. So there's a risk there. OK. And SIPC doesn't mean

your stock goes down in value, you're SIPIC means your brokerage firm goes down in value, you're covered. The SIPC coverage. Okay. But because of the Securities Investor Protection Act of 1970, they have to have collateral, as in the brokerage firm has to have collateral in order to provide this, meaning there is something there in lieu of SIPIC. So I would say the risk to you

is really, really low. There's always risk. So I'm never going to say there's no risk, but there's minimal risk. But there is a downside. Yeah. What's the downside? Think about how the stock market prices go up and down in value. It's buying and selling supply and demand, Right. If people are selling out of stocks, that puts pressure, downwards pressure on price. If you have more ability to short, that's more downwards pressure.

So you're creating the ability for high short interest. Does that make sense? Is it because these people who like to short sell stocks, they're seeing that there's a potential for the stock to go down in value. That's the intent. They're kind betting on it, like getting worse so that they can make a profit. The stock is a certain price right now, but then they can tell that it's about to like go down. So they sell it now while it's high before the value goes down.

That's right. And sometimes it's for tax purposes too, and that gets a little advanced, but yeah, that is absolutely why. And if you short sell without an offsetting position, it's unlimited risk. So they have unlimited risk. When we had that episode about the short squeeze and gamma squeeze, we talked about GameStop, obviously, because everyone knows about that one, but that's kind of what those hedge funders saw. They're like, GameStop's not doing well. This company is like tanking. We should short sell them because the stock value is about to drop drastically.

And then of course all the fans of GameStop and editors were like, no, no, no, no, we're going to not let that happen. that's like rare. That doesn't normally happen. That is not normal. it's well, it's we should link to that episode because if there is a bunch of short interest because it has unlimited risk and if the stock does increase in value, that means you have higher margin requirements. And if you can't meet those,

you're forced to buy to cover, which could artificially create a bunch of buys, which then sends the stock price up. So this is like the inverse of this. You're creating the ability to have a lot of sells by lending your shares out. You're saying, yes, you can sell my shares. That's going to clock in the market as downwards prices, not upwards prices. See what I mean? That's the downside. And if you're doing this in a taxable account and you get

cash in lieu of a dividend, that could be taxed less favorably for you, as in that could hurt you tax-wise. So are you able to lend securities from like a Roth IRA? Yes, you can. Okay. See, and the things I didn't think about before being like, yeah, sure. It was my entry into kind of paying attention, like I'm going to buy this stock and see what happens before we had this wonderful educational podcast about

all the things I didn't know about. Hey, so yeah, it's one of those things where it's like, let me just like kind of see how this works, which you probably want to know before you put your money into something how it's going to work. But yeah, that's why we're here. That is why we're here. Absolutely. And just like when you sent me that first email, it this does look too good to be true. It's like, hold on, I can do nothing. I can give you my stocks and you're going to give me like seven, five or whatever. Yeah. Yeah. Except.

Exactly. And it accrues daily too. So always an annualized rate, but it's a daily accrual because margin works through hold overnight activity, almost like batch processing. okay. Yeah. So if you had like $100,000 worth of stock that you lent out, so maybe, I don't know, a thousand shares at a hundred dollars per share. I'm doing easy math again. Yeah. And your annualized rate was seven and a half percent.

you would get $20.83 a day for doing nothing. Monthly, that's $625. That seems like a... How often do you think that happens? It happens if you have a big account. Yeah. So that's another way to live off of your portfolio at some point, whether it's retirement or just a regular investment account that's not a retirement account. I guess this is another way of doing that, making extra money. It sure is.

Because it goes back into your account as cash, right? It does. Yeah, it does. So you can either buy more securities with it or you can cash in your other accounts. exactly. That's it. There's definitely some downsides. But for you, the person lending it, you just got to know you're relinquishing ownership. It could be taxed a little differently. Selling pressure can be bad for stock prices. And it changes also from supply and demand, as in...

It could have a high rate today. It could have no rate tomorrow because it's not hard to borrow. So it's not like this is anything that's consistent that I would bank on. OK. But it is available if there is high demand. And what about James's question? He seems to think that brokerage firms might take too large of a percentage of the profit. I mean, there's nothing we can really do about that. But do different brokerage firms take different percentages? Or is it regulated that they can only take a certain percentage? I don't think there is a specified regulation of

the amount that they can capture. Do they tell you that when you sign up for the program in November? I don't think so because they set the hard to borrow rates as well. So they're setting the rate to the person who is on margin, which is risk that they're taking because firms do take losses on accounts sometimes when they go negative. have seen it. They've woken up in the middle of the night with certain situations. Yeah. It's insane. That's on the margin side. So to prevent that.

That's why hard to borrow rates are there because it tends to be risky and it's discouraging you from holding it overnight to have that type of risk. It's all really methodical if you think about it. OK. They're giving you a portion of that. But in order to do that and facilitate that transaction, there's operating cost. So I'm OK with them taking a larger portion. That's fine. It's still a big interest rate. that you're getting like 5 % or 7 % or whatever it is when you sign up for it. So you should be getting that no matter what. And you're agreeing to that.

and they get whatever they get is what they get. mean, you're getting your 5 % or whatever it is. I'm trying to figure out strategically if it's securities that you're planning on holding for a long time anyway, then it doesn't really hurt you to lend them out unless you really want to participate in voting rights and things like that, Exactly. And also that 5%, that changes every day. Could be different for every security that is not set in stone. that's good to know. I did not realize that.

all based on supply and demand. When you don't want to do it anymore, you have to like go back and opt out somehow. Yeah. Call them up. Not that I want to sell my stocks. I just like don't want to do this anymore. Exactly. You can be like, I want to opt out. Give me all my stuff back. That's it. Yeah. OK. So I mean, yeah, it's interesting. think definitely assess your tax situation and how the money is coming into your account that you're lending.

stocks or securities on, make sure that that makes sense for you. And especially like depending on what scale you're doing it at. Do they just get access to all of the stocks and securities they want at any time? Like, so say I signed up for the program and then I buy shares of like a new stock or something. Like I signed up the program years ago and I just bought Nvidia stock earlier this year or something. And now they want to loan that. Do they have to tell me first or they can just like take whatever they want in my portfolio?

Well, you opted into it. I'm sure it varies from brokerage to brokerage firm from the one that I worked in. They would just identify it from your account, but you could clearly see it on your positions page. So you signed your account up for it. Your account is now in this room where it's, hey, we can grab from this room if we need it. Where they couldn't touch the cash room. The cash room's restricted, but you took yourself from the cash room and you put it into the lending room. So they can go into the lending room, but you can clearly see on your positions page.

you will see that it's lended out and you could see your daily accrued interest as well. So when you're doing your quarterly check-ins with yourself, make sure you're looking at your positions page and if you're doing stock lending and how that's working out for you and if you want to keep doing that. Yeah, that's it. We're just here to educate and explain and say this is how it works. Here's the risks. If you want to do it, it's up to you. Okay. Well, there's always something to learn in the self-directed investing space. And if you learn something today,

Please share this podcast with a friend. helps us grow, and we would appreciate it. Yes. Leave us a review. Tell us how you really feel. I like reading your comments, to be honest. And I will write you back novels. Yeah. She will. And of course, if you have any questions, please send it our way. We do our best to answer every single one. And literally, as some of you know,

I will send you back a very lengthy email with links and resources. I enjoy doing this. Or like today, you might even get an entire episode dedicated to you. And you can reach out to us on all of our social channels, all the links and the show notes, as always. Yes, and remember, when you build knowledge, you break barriers.

Remember, investing involves risk. There is always potential to lose money when investing in securities. Market MakeHer provides educational content and resources for informational purposes only. We are not registered financial advisors and do not provide personalized investment advice. Any information provided by Market MakeHer on our website or podcast is not intended to be a substitute for professional financial advice. Market MakeHer is not...

liable for any investment decisions made based on our content.